Economists should look to weather to realistically forecast future crisis

Mark Buchanan

BEFORE the global economic meltdown, economists were a confident bunch. Markets were more efficient than ever, and were so because of the wonders of financial engineering based on economic science, they asserted. Capital markets were driving economic growth, creating jobs, and guaranteeing the stability of the economy against recession.

Some even claimed that modern markets had made governments more efficient. "By providing immediate feedback," two particularly enthusiastic economists gushed, "capital markets have increased the benefits of following good policies and increased the costs of following bad ones." Obviously, something in all this wasn't right. Markets were not as wise, efficient, or as stable, as theorists imagined. A housing bubble and credit binge, fuelled by an orgy of financial innovation, turned the global economy into an unstable explosive, which duly exploded.

I don't think any academic economist lost his or her job over this spectacular error in judgement. Even so, it's clear that the overconfidence of many market theorists helped cause the crisis, and certainly made it worse. Now, as instability continues, we need some more realistic ideas for understanding markets. Where do we look?

A central notion of contemporary economics is that markets naturally seek a stable and efficient balance, or equilibrium. The idea makes for tidy mathematical theory. Yet the notion of stable equilibrium looks ill-fitted to economic history, which is characterised by incessant turbulence, with crises hitting one after another across the centuries. Calm gets wrecked by upheaval. To use a crude analogy, history looks as unbalanced as the ever-changing weather.

In fact, this is more than a casual comparison. Mathematically, this analogy goes quite deep. Many of the basic statistical patterns describing the dynamics of markets are virtually identical to those describing the dynamics of weather (and many other natural processes). But the notion of balance and equilibrium plays only a minor role in atmospheric science, which has built powerful and valuable theories with ideas emphasising imbalance, and focusing on the natural feedbacks that drive persistent change.

Maybe economics and finance could benefit from similar thinking? Economists for the past 50 years have mostly ignored the possibility, and most still do. An army of theorists is toiling away to see if the crisis of 2007-2008, with enough imagination, might be viewed as the efficient consequence of some mysterious balance among the interests and plans of all the economy's actors. But less absurdly, quite a lot of thinking since the crisis is taking the idea of disequilibrium seriously and building useful insights.

Theorists are toiling away to see if the 2007 crisis might be viewed as mysteriously balanced

Much of the economic justification for the proliferation of derivatives instruments over the previous several decades, for example, is that these instruments make markets more "complete," so essentially any kind of trade can be undertaken. Yet physicists have demonstrated that striving for the ideal of complete markets shouldn't lead to a nirvana of market efficiency. Relax some unrealistic assumptions, and we should expect any market to grow increasingly unstable as it becomes more complete. The theoretical justification for derivatives was a myth.

Other research has shown that stabilising the financial system demands study of the architecture or "topology" of the webs of connections between institutions. Economists traditionally considered financial stability by looking at the health of banks on an individual basis. But the staggering complexity of finance today requires a more holistic perspective, focused on how imbalances can move through the web of links. The current system seems wired up to make trouble spread too easily.

The complacent use of equilibrium as the only conceptual tool in economics restricts the things economists can imagine happening in the world, and confers a mistaken sense of safety. We'll never understand economies and markets until we forget the idea that they alone - unlike almost every other complex system in the world - are inherently stable and have no internal weather.

Of course, no better science of finance and economics will ever eliminate crises. But by facing up to natural instabilities, rather than ignoring them in the interest of pretty mathematics, we're more likely to find our way to a more stable financial future.

Mark Buchanan is a theoretical physicist. His new book Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics, is published by Bloomsbury on 11 April 2013.